RBC Global Asset Management recently published its third annual Responsible Investing Survey, and My-Linh Ngo, ESG investment specialist for the firm’s London-based BlueBay Asset Management division, offered PLANSPONSOR her take on the results.
At a high level, the survey results suggest institutional investors in the U.S. are rapidly warming to the utilization of environmental, social and governance (ESG) factors when building out their portfolios—and many are already implementing their own takes on ESG investing. Notably, the percentage of U.S. institutional investors that reject ESG considerations outright shrank dramatically year over year, from 51% to 34%.
As Ngo pointed out, equities have long been the primary focus of ESG analysis and investing, but these days ESG analysis is quickly moving beyond equities. Thirty-percent of respondents in the U.S. said it is important to incorporate ESG into fixed-income considerations, Ngo said. Asked directly whether they incorporate ESG into fixed-income management, 52% of U.S. investors that already use ESG said yes.
“Our company has a core belief that ESG considerations are investment additives, not a hindrance to performance,” Ngo said. “Thinking about ESG helps us to generate a more holistic and informed view of how companies are performing, or are likely to perform in the future. So, we are applying an ESG risk overlay across all of the fixed-income assets we manage. It is not something that we limit to niche funds.”
Of course, the specific approaches BlueBay applies will vary across different products and geographies—but ESG risk overlays “come standard with every fund and investment product,” Ngo said. “We do it this way because we see ESG as something that can be quite beneficial in terms of measuring and addressing downside risk, especially on the fixed-income side.”
More Sophisticated Than Simple Screens
According to Ngo, providers these days are taking a much more sophisticated approach to ESG than just running simplistic negative portfolio screens to avoid bad apples.
“Today we are conducting sophisticated analysis on the investment materiality of key ESG factors, and we are doing this in a rational way that looks across the entire institutional portfolio,” Ngo said. “I must stress, this work is not about running a bunch of negative screens, but instead it is about being scientific about how you build portfolios and truly acknowledging the risks you take.” It’s an unbiased, pragmatic approach that is grounded in focusing on the impact on investment performance.
Like other ESG advocates, Ngo said she was somewhat frustrated to see the most recent regulatory guidance issued in the U.S. on this topic—the Trump administration’s DOL Field Assistance Bulletin 2018-01. Ngo said this guidance is largely unhelpful and even potentially misleading, as it seems to discourage consideration of ESG factors by retirement plan sponsors while at the same time doing nothing to actually supersede the previous regulatory action, the Obama administration’s Interpretive Bulletin 2015-01, which encouraged more use of ESG. In the end, Ngo said, the demand for ESG is coming from investors themselves and is ultimately unlikely to be derailed by a lack of regulatory clarity.
Fixed-Income ESG Is Similar and Different
Before taking a deep dive into the mechanics of ESG fixed income, Ngo first highlighted some of the ways that the analysis mirrors what is seen on the equity side of the portfolio.
“In absolute terms, both ESG equities and ESG fixed income are not quite mainstream yet,” Ngo said. “They are getting there, and in relative term, ESG thinking in equities is more mainstream. Another similarity is that both sides allow investors to come at ESG from both the business/economic perspective and from the values/beliefs perspective. We feel that, in both cases, ESG can benefit long-term risk-adjusted returns. Finally, both ESG equities and ESG fixed income still face similar issues in terms of inherent challenges of visibility and understanding in terms of the breadth and quality of the actionable data that is available.”
This point is echoed by recent Natixis research, showing 45% of institutional investors feel it is difficult to measure and understand financial versus non-financial performance considerations when establishing ESG programs. Some of their concern may be based on the criticism received by CalPERS and the New York City pension funds following fairly enthusiastic ESG implementation and fossil fuel divestment efforts. However, the Department of Labor (DOL) and other regulators and resources have offered extensive guidance on the topic as it pertains to retirement plans, it should be noted.
Moving on to the areas where ESG fixed income is different from equities, Ngo first pointed to the fact that on the equity side, generally speaking, investors can choose from a large universe of unique issuers, but at the same time the instruments they can invest in to get exposure to these companies are quite limited. Usually it is one share class or possibly two, Ngo said.
“What this means in practice is that you can take a very fundamental view on the equity side of whether you want to have investment exposure to a given company or not—because they only have that one vehicle and thus only one singular investment risk profile from the ESG perspective,” Ngo said. “This allows you to more easily build in your fundamental view directly into your decision of whether or not to invest in this company.”
On the fixed-income side, essentially the inverse is true.
“You have a smaller pool of unique issuers, but each of these has a larger pool of instruments you can invest in,” Ngo said. “What this means in practice is that each issuer will have a variety of different bonds that have different yields and different maturities. The different bonds will afford different levels of protection, as well, depending on the structure of the capital pool and how the bond is built. Thus, in practice, there are multiple credit risk profiles to consider for each issuer, depending on the bond that you choose to invest in. For this reason, the ESG analysis for fixed income is made that much more technical and quantitative.”
Another major difference to consider, Ngo said, is tied to the fact that equity markets “are so much more sentiment-driven relative to bonds, and they move at least in some degree according to what people are anticipating, with or without evidence, about the future.”
“In practice, this means a mere rumor can impact the share price of a company,” Ngo said. “Even if it is unsubstantiated, if there is a perception of risk this will be reflected in the stock price immediately, and potentially in quite a pronounced way. But when you look at fixed income, the credit rating is a more stabilizing force, in a way, because it is looking at the narrower but more extreme risk of the potential for default of that issuer. There are other risks in between, in terms of credit downgrades or upgrades, but it’s all much more tied to the real balance sheet of the company and how this relates to the maturity of your debt holdings.”
Based on these facts, Ngo said the determination of the materiality of ESG risks is more subtle on the fixed-income side, but also more ripe with possibilities.
“As an example, let’s say you have an energy company and it is very exposed to climate risks in the long-term, and let’s also say you have one short-term bond from the company and one long-term bond in your portfolio,” Ngo said. “Well, you can pretty easily argue that the ESG risk is less significant, potentially much less significant, for the short-dated bond, while the same risk is very material to the long-term bond.”
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